Absolute Credit Series: Recent Trends in Rated Note Funds

LT (00:11)
Good afternoon, everybody, and welcome to the Kirkland ABSolute Credit vlog. I am Lindsay Trapp. I'm a partner in the New York office, and I am joined today by Kate Luarasi, my co-head of the Structured Capital & Insurance Solutions team here at Kirkland.

Hi, Kate.

KL (00:25)
Hey, so great to have you on board. I'm thrilled that you finally decided to join us and really excited about putting our heads together and creating some new structures and adding to the market in this space.

LT (00:39)
Absolutely. I am delighted to have taken up my post here at Kirkland and it has certainly been a whirlwind journey for the first few weeks and it's been wonderful. So really excited to be here and working with the whole team. It's been fantastic. [crosstalk]

KL (00:54)
[crosstalk]
We specialize in the whirlwind! Welcome.

LT (00:57)
We do, we do, absolutely. I thought it'd be great to just give some updates to folks in the market and maybe for those of you who are joining us for the first time and aren't familiar with the Rated Note structures and kind of just a little bit of background about why we use them and what our practice is all about. So I think in their first nascent stage when you and I first started doing these, like in the last 10 years, [laughter] ⁓ they started obviously, sorry, last month or week.

So, you know, when we first started doing these, these were largely a designation to restructure slightly an investment into a private fund to deal with the fact that insurance companies, particularly in the U.S., get treated as having an equity investment in a private investment fund, regardless of what that fund actually invests in. So you'd have an equity capital charge for risk-based capital, even if you were investing into a credit fund. So I don't know about you, but certainly in the first versions of these, they basically looked like a fund with a couple of tweaks that said, you know, and part of this is debt. But that is certainly not where we are now. So I thought today maybe we could talk a little bit about what we're seeing in the vertical space. For those of you who are unfamiliar with that term, vertical basically just means that it's an expectation that the same legal entity or economic group is going to take both the debt and the equity in the structure. So a vertical strip of all of the securities that are being offered and horizontal structures, which we have seen growth in massively ⁓ for the last little while. And that term essentially just means that we're placing the equity with separate parties from the debt tranches within the structure. So.

Give me what you got, Kate, on the verticals lately. What's the biggest kind of thing that you've been seeing in that space?

KL (02:52)
So I guess I'll start with it's increasingly complex. It increasingly attracts different kinds of insurance companies, not just life insurance, but others as well, maybe lesser check sizes. But the investor pool has grown, the complexity that comes with it has grown, the investor requirements to come into the structure has also grown. And this is before we even get to the horizontal. You know, now we're more likely to see at least two tranches of debt rather than when we started a month ago, [laughter], all there was essentially like one strip of debt, one strip of equity. And now that has evolved. But, ~ I guess the overarching note here is that we're seeing increased sophistication and growth. And, that is inherently leading to the complexity of these structures and also to the value add from our perspective, certainly as attorneys, and also from a client investor and intermediary perspective. We'll talk about horizontals in a bit, but we are seeing, ⁓ even in the vertical context, we're actually seeing the size of the RNF feeders grow. So what started with maybe $50 million here and there has now, like a lot of them are $250 million plus.

There's still some idiosyncratic requirements here and they tend to be fed by an anchor investor or seed investor. Some of them come in and they want a single commitment, others want multiple commitments. they can, even if they're buying the entire vertical, like Lindsay was saying, they want the ability to kind of parcel on the backend and place ⁓ maybe the equity or parts of the debt on their platform, still held by one affiliated complex, but they want to kind of slice and dice on the back-end. So there's that piece as well. We're also increasingly seeing investors that come in, they want the entire vertical because the return profile blended makes sense to them. But they want some features that they are seeing in the horizontals. So they want a security interest, they want perfection, they want opinions, ⁓ attendant opinions that kind of go along with that. But overall, I think it's a sign of depth, increase in size and increase in sophistication.

LT (05:10)
Yeah, absolutely. I definitely think certainly seeing quite a few very large placements in the vertical feeders. And I think some of that has to do with the fact that they are decoupled interests from and, you know, from a legal perspective, we have to draft them and make them structured in a way that the equity can be sold separately or at least transferred and held separately from the debt, which ultimately what makes it vertical, I guess, for folks to think this through is just there's a different commercial position when a single economic group is holding both the debt and the equity because it kind of ultimately is all going to the same pot. And so that sort of inherent difference between what debt investors are expecting and what equity investors are expecting is not as present. That's not to say that there are certainly not considerations around both of those, but it's very different to what we're seeing in horizontals, which is certainly important. But I think for insurance companies and as they're thinking about it, that ability to be able to hold the debt and the equity in separate entities within their group or separate parts of their book is quite helpful because with the NAIC's increase in the capital charge on equity for these structures to 45%, I think that's driving a lot of this sort of desire to have separate entities hold. And sometimes we will see people hold a mix. So one entity holds the senior notes, another entity holds the junior or mezz notes, and someone holds the equity or holds those lower tranches as a package. There's certainly a lot of chopping and changing. And it's very important as a manager to kind of think through how that's going to be structured within your wider fund structure. And from our perspective, from a legal perspective, we do have to think about it very much as, you know, this is debt, this is how this operates is debt. It's how that mechanic flows through the wider fund structure and kind of dealing with the master fund in that context.

Horizontals seem to be, I won't say the flavor of the month, but, you know, certainly I would say probably three years ago, it was every now and then you'd see somebody with a horizontal. Now, I'd certainly say we're seeing probably 50% or more at this point in horizontal sales, which certainly has increased a massive amount of the size of these vehicles. We just worked together on a big deal that brought in $2.3 billion in a structure. And so that's all insurance capital. And I think that that just goes to show how much this industry has evolved, and so horizontals are a very big part of that. So I guess in that particular space, you know, what are you seeing as the biggest issues between the tranches in as far as the investors are negotiating?

KL (08:00)
It's a very exciting space. I definitely agree with you. I think we're probably up to like 50% inbounds on horizontal structures. Some of them have a little bit more acute pressure points and some discomforts and reconciliation between a true horizontal structure in a feeder and the underlying fund. Not to say any of them can't be resolved, and we'll highlight some of them here, but there is a little bit of incongruity between the feeder that's being offered as a horizontal and the main fund. To your point on what investors are kind of looking for, I guess from a structural perspective, one of the key differences that you can optically determine just by looking at it is in a horizontal, you're much more likely to see a minimum two, but usually three or four tranches of debt. And sometimes we also see tranching of the equity. So, you know, you might have an actual pref before the residual or the residual itself might have like a “class one” and ⁓ “class two”. And that's [not] just for payment priority purposes.

When it comes to negotiating, as you mentioned earlier, like the investors are coming in and it's no longer a singular entity negotiating on behalf of all of the entities in the backend, like all of the affiliated entities that will hold the vertical. It's every man for himself. If it's a senior note holder, they are counting each penny before a payment is made on their debt coverage. That includes interest. And if it's a residual holder, they're actually kind of doing the same because they want to prevent leakage outside of the box. And they also want to kind of tinker with, one, the ability to receive some distributions either for tax purposes or plainly just to maintain that LTV ratio during the investment period. So they're looking to receive some distributions while the structure is in play. But overall, they're also looking to see and they're more motivated to cap org expenses, or in this case, you know, the transaction expenses. Everybody's very much focused on the priority of payments and making sure, you know, who gets paid what, when. Administrative expenses are much more likely, if not always capped. There's a catch-all of course, at the end before the equity, but the equity sometimes even tries to cap that to make sure that, you know, [cross-talk] Exactly, that they're getting some cents on the dollar if things go astray.

So those are all normal course, but it's just everybody has their own interests in mind when negotiating the terms. They're inherently far more complex as a result. And it also has much longer timeline in terms of coordinating some of the cats and herding some of the cats here. So we have intermediaries of the structured agents, placement agents. You know, we have certainly we have the rating agencies on the horizontals, you're much more likely to see two sometimes. And the verticals you never see two. And then obviously, you know, it's the attorneys, if you have investors counsel, they can actually be really helpful in herding some of those cats for you. So that instead of, you know, kind of having to address each individual lender or each individual equity comment memo. They can kind of help aggregate those, consolidate to the material positions and kind of present it in whole, keeping fees, timeline, everything else down. And we like to help our clients with that as well because we think it's a key component of making sure that these are, Lindsay and I have talked about this, I don't think they'll ever be truly commoditized. But I think there is a lot that we can do as service providers to help kind of cement some of those guardrails and usher everybody towards the closing gate.

LT (11:54)
Yeah, absolutely. I think, you know, it's important for people to kind of think through and realize, like, obviously in a vertical, it's the same structure. You have a fixed return to debt. They are only going to get the interest coupons and the principal. The equity is going to get all of the residual upside of that, but they are also bearing all of the fees. But when you have that as your sole piece that you are just getting the residual and you are bearing all the fees on a levered amount, you are not getting what the debt gets. And equally for the debt folks, they are solely getting principal and whatever interest coupon is coming with their particular tranche. It certainly creates a lot more kind of thought process and complexities in negotiation between people, rights in things like an enforcement ⁓ issue, that type of thing. Verticals still, notwithstanding the fact that, yes, on occasion we do get someone who wants to secure them, oftentimes verticals just remain unsecured, whereas horizontals are pretty much universally secured debt. So you then are looking at what is the collateral package? If you have a wider fund structure as well, what would happen in enforcement? Is this structure that sits below this particular issuer capable of having investors come directly into it? Sometimes we have fund structures where the master fund is solely designed to have feeders. And so then you kind of have to work on what that enforcement actually would look like and sort of deal with that and how your collateral trustee is going to kind of handle that. So there's quite a lot of things to think about in that type of thing. But I also do wanna talk a little bit about the features that might make these a little bit more operationally, not necessarily cumbersome, but things that people in the manager-side space should be thinking about that investors as they're looking at these are going to focus on.

Certainly one of the things that I think we've both come across is verticals oftentimes were revolving debt. Horizontals are not. And so you end up with debt that needs to be drawn. And then that cash is generally never going to go back out during the investment period. So if you have something like, you know, we return capital during the investment period and it's subject to redrawing, that cash is going to sit inside of this feeder vehicle. And so there needs to be other thoughts about, well, what can we do then in that context for the equity returns so we don't have a bunch of cash drag? So we oftentimes will see fairly broad other assets, types of investments that folks can make, definitely traditional cash management, liquid paper, that type of thing, but certainly have seen somewhere there are more things like ETFs or the managers’ '40 Act funds or other types of liquid strategies that folks are seeing in there. And then I know you and I have certainly talked quite a bit about our favorite, which is conditions to funding. Maybe run down a little bit on, you know, where that can cause some issues.

KL (14:45)
Absolutely. So I think, overwhelmingly, these horizontal structures tend to pair better when you have what we would refer to as like a CFO or a fund-backed note, where it's a standalone vehicle and it's actually feeding into a pool, whether it exists at closing or not, but it will feed into multiple fund interests and maybe they're staggered or maybe there's a lot of diversification. By virtue of that pool, at any given moment, it presents different needs, right? So you're not gonna have the need to draw down all of the capital at once, but maybe over a shorter period of time than you would with a true normal-course single fund investment. In the latter, you're much more likely to have like a 12 months drawdown period, 18 months, sometimes, dare I say, 24 months and, you know, with extensions to boot. If we're all putting our lender hats on, nobody wants a commitment outstanding for that long. Like the ideal for a true lender is, you know, they're coming into this, but nobody wants to provide a revolver. But even with a delayed draw, they're looking at it as, you know, what am I getting while this money is committed? And to your point on CPs, while we have this prolonged period of time, there's CPs in the credit documents. So you can't have a lender fund into, I don't know, let's say things have gone all the way back. They can't fund into an event of default, and you can't force them. Whereas when you have an equity investor or an investor that's taking that entire vertical, the motivations are completely different, and they know that they would have to fund in any event, but for a lender, they don't have to fund. So there's this period where the CPs are in effect, you have pressure from the lender group because they want to fund and they want to fund ASAP. They don't want to draw it out. The sub-line lender is much less likely to give you credit. So there's a little bit less cash management or like tooling options downstairs. And we can talk about that as well.

But yeah, there's these friction points that kind of form an amalgam, and it's a little bit uncomfortable when you're, when you have a single fund investment and you want to maintain the same flexibility as you would otherwise have with a vertical where you can have the revolver or you don't necessarily have the CPs, or if you do have them, everybody's still motivated to fund because they have to fund anyway. Honestly, it's essentially like having your cake and eating it too. And we understand like, everybody's kind of coming to the table and negotiating for their cake and they want to eat it as well. But ⁓ from a sponsor-side perspective, that is one of the key components where, you know, we understand the motivation to lean towards a horizontal. It might have a bigger market or they might have an equity investor lined up and now they just need to sell the debt or they might even be able to hold the equity themselves. So there's a lot of, favorable aspects to it, but there is also a lot of key considerations that, you know, you and I work with our clients a lot to put into play and make sure that everybody's well-advised of what those guardrails need to be and has a plan on a go-forward basis. And certainly CPs and that mismatch between the commitments at the feeder level that are subject to CPs and the issuers' actual hard, unconditional commitment to the main fund, that's a big component there.

LT (18:11)
Yeah, absolutely. You know, that's not the only thing we certainly think about. Another thing in these is that because we tranche them out so deeply, that often means that there's a relatively small, comparatively, you know, piece of equity in those structures. So one other thing for folks to think about if their fund, you know, typically more commonly closed-end master funds, but sometimes in evergreen master funds, depending on the structure, if there is a give back, ⁓ or LP clawback situation, you don't get to get money back from debt. So oftentimes, you need to think through, how much of a mismatch is there between how much we have in the equity, which in general, we typically require all distributions made to the equity throughout the life to be recallable into the issuer, just in case there is this type of issue. So kind of balancing out what the feeder's obligation is to the master and any limitations on that total amount and how much equity you truly would have.

And so for everybody that's kind of thinking of investing in a whole sort of fund complex and whether they become the investors coming into the master fund or investors going into another feeder or investors coming into the rated feeder, there's certainly things that occur with rated feeders and how they operate, particularly in the horizontal space, ⁓ that certainly should be discussed with your council ⁓ or if you're coming to us, we will happily take you through all of those different things and the various experiences we have had. Certainly, there's new ones every day, but we've definitely been through quite a lot. So very happy to walk through those. I guess the other thing that we see a lot or certainly a question I think you and I get asked on every single call we do is: where do we find equity for these structures? It certainly started out, I think, largely that the managers oftentimes would take down the full equity tranche or the vast majority of it. Certainly have seen a lot of interest lately in third parties coming in. From my side, of seeing family offices, hedge funds, other types of fund investments. But have you been seeing similar things in your funds?

KL (20:21)
Yeah, absolutely. I think strategic partnerships have become a very large, critical and significant component of this market. A lot of times our sponsor clients will actually come to the table and say, I've lined up a hundred million of equity. you know, like …

LT (20:39)
We need the debt.

KL (20:46)
Exactly, it's essentially like the inverse of what the historical problem was that you already highlighted, you know, where are the equity investors? I think overall, it's still a little bit more tough to place that equity, especially where you have a single fund underneath and that fund, you know, it kind of cuts both ways. It's easier to get a rating on a credit fund. And, you know, the easier part is just on the getting a good rating on the notes. It's harder, however, to get the type of return profile net for the equity that's actually going to incentivize equity or, you know, typical equity investors to come in and hold that residual. They're looking for a very specific return profile and it tends to be harder to generate that when the underlying fund is like senior direct lending or something along those lines. It needs to be a little bit spicier to actually draw third-party equity interest.

LT (21:39)
Yeah, particularly the unlevered master funds. I've certainly seen it as an option for providing a levered version of a fund as opposed to having a separate sleeve that's doing ABL. But it is something certainly that investors that are coming into the equity should think through what their profile desires are and what they would like to do and kind of taking into account things like the fees are being paid on the levered amount and that type of thing and how they would generally do that. I guess the last thing in horizontal world that you and I have both been facing recently that we love to chat through is MFNs and kind of generally, you know, there's a lot to think about in the context of a horizontal. In a vertical, an MFN, the whole total amount is generally coming from one investor. So it makes sense that it's a relatively straightforward process comparable to MFNs in the wider fund.

But in a horizontal, there's very different considerations within that structure. And so certainly, I think managers and investors alike should be thinking through how that should ultimately compare or should it even be included in the context of the MFN of the wider fund because it is such a different position. And really, I guess in horizontals, we're thinking more through MFLs because it isn't really just most favored investors, kind of wider, it's really most favored lender type of clauses and they don't bear economics generally. And we have reading considerations so you can't really change their interest rate or anything like that in side letters, but ... certainly have seen a rise in asks for MFNs from lenders in my side. So what have you been seeing in that space?

KL (23:22)
Definitely a rise in requests where I think for years and years ... I mean, take a step back, Lindsay and I like to geek out together. So this is what we're, we don't just talk about MFNs. We talk about any and everything.

LT (23:34)
We talk about all things. We are nerds, yes, actually, yeah, we are.

KL (23:38)
But yeah, MFNs have been coming up a lot, and you don't really see MFNs in the debt space. But, I guess, you know, when we've been putting our heads together, one way to rationalize it is the investors that are coming into the space have very specific needs. So it's almost like addressing the difference in a direct lending facility. It's almost like addressing the difference between a BDC and, you know, a private credit fund, unregistered of course. So they're going to have different reporting pressures and confidentiality and similar restrictions. And it's kind of incumbent on whoever is drafting the documents and whoever's negotiating on behalf of all of the parties to reflect something in the documents that everybody can kind of live with. There are certainly bespoke circumstances and nobody's not like the equity world where there might be different economic arrangements. This is class by class, and as among the lender group, the terms are in the actual credit documents.

But yeah, definitely seeing a lot more inbounds on reporting, disclosures, and more recently, our favorite that we've been putting our heads on, these pledges, because insurance companies fall into that very bespoke lender bucket. And a lot of them are either subject to or they have reinsurance agreements in place. So in addition to wanting to kind of turn around and parcel these investments among their own affiliates, in many cases, they actually want it to count as eligible collateral for a reinsurance arrangement. So then, you know, we put our heads together with the sponsor and kind of see what the transfer provisions can and should look like. But that's the colorful array here. And I guess for our clients, these are the types of issues to keep in your back pocket and in back of mind as we negotiate the MFN provisions and the underlying fund as well.

LT (25:31)
Yes, absolutely. It's very important, I think, in general, you know, when this first started and when we were both children, clearly, you know, we used to kind of get called up and asked if we could do a rated feeder into a fund that was coming up to its final close, or it was kind of already in there. But as the market has shifted, a lot of funds start out with a rated feeder. Sometimes they are the actual seed vehicle. So it is important if you aren't planning for a rated feeder or if you're just thinking about it in the beginning of a fund kind of setup and structuring that you reach out, let us kind of walk you through some of the things that might be important in your master fund documents to kind of think through and how might that work with having a rated feeder, having multiple rated feeders, evergreen structures in particular as well. We do a lot with that and we are going to do a whole separate episode for you all since we've been asked so many times about different things for evergreen funds. So we'll be joined by our other partner, David Miller, soon on an upcoming episode where we will talk all about our extreme geek nature of loving evergreen structures with rated note feeders ⁓ or our favorite lately, ⁓ evergreen rated note feeders. ⁓ So, you know, we'll cover that, but I think it's important to think through if you do have an idea that you might want to put a rated fund onto your master fund or even side-by-side with it, just sort of thinking through, understanding that stuff from the beginning. It does not have to come in at the first close. It can come in at various points, but there are certainly a lot of things that it's important to sort of think through in advance before you have things to bait because you don't want to have to go to investors and ask them for accommodations for another feeder.

So jumping away from our friends rated funds into slightly different versions of them because today's discussion is a lot about evolution, I certainly have seen over the past year or so since the end of 2024 when the UK regulators adjusted the ⁓ matching adjustment positions to having self-certification and highly predictable cash flow positions, certainly seen a huge sort of rise in doing these structures in the UK or for UK insurers more accurately. And so I think that that's something, you know, people are often asking, where are you seeing, you know, new things, new appetites, that kind of thing. Certainly from my perspective, we're seeing a lot from the UK. There's a lot to consider there, and we will do kind of a separate episode on this, but I do want to just get it out there because we are getting so many calls about this that oftentimes the matching adjustment structures do not suit well to being a feeder fund. It is not impossible, but they simply don't fit quite right with the way that funds typically operate. There are requirements on how you can stage drawdowns. There are requirements that you have a scheduled amortization. There's no deferral for longer than 364 days on interest coupons. And so those types of things just don't tend to lend themselves well to the way that funds operate. So just if you're thinking about doing that, of bear that in mind, bear in mind that each insurer will have its own views on what will satisfy matching adjustment and what will not satisfy matching adjustment. So it's going to be unlike sort of a typical rated feeder raise where you can build it and they will come, in often cases, you know, or you have kind of one investor and if you build it for them, it'll be, you know, pretty close to what other people want. These ones tend to be a little bit more in the, you need to find people that have similar alignment on what they think in order to kind of get them across the line. So. I did want to just kind of highlight that.

But the other thing that you and I have been doing quite a lot of, and we're lucky we've been having a conference here over the last few days, so a lot of our colleagues from rating agencies and other places have been in town, CFOs are everywhere, everything. We see them constantly getting asked about them. We do quite a lot of them. So just kind of high level, we will do an episode on that as well. ⁓ But high level, know, kind of anything that you see as a particular difference between rated note funds and CFOs and kind of if someone's thinking maybe one way or the other, you know, what features would you say of their underlying pool might be important to consider in the context of a CFO?

KL (30:10)
Absolutely. So yes, lots of inbounds on CFOs and lots of them getting done faster and faster lately. But I tend to think of them as setting up a horizontal structure, but the most complex one that you could possibly have. Just to take a step back for our audience, ~ if you don't know what a CFO or a collateralized bond obligation is, sometimes they're also referred to as private equity-backed notes, fund-backed notes and you might've seen some of them in the headlines lately ~ but essentially what it is, is a pool of interest in various funds and the more diverse, the better the, you know, the more like different vintages, the better. I guess from an NAIC perspective, the key focus would stick, which is true for verticals and horizontals, into one fund as well. The key across all of these structures will always be how much cash is coming up from the underlying assets. Are they self-liquidating? Is there a general onus on the issuer to otherwise, you know, generate a liquid bucket somewhere else? Like, you know, very important to make sure that you have a stream of cash coming up to support the debt coverage. And that's principal, interest and that gray area in between, which is deferred. So what do we mean by more complex? Everything is being negotiated. So we've mentioned some key components throughout this vlog. Some of them will include amortization. Some of them include a drawdown schedule. All of them will include a ticking fee if there is a delayed draw component. There is a very short availability period, if there is one… All of the intermediaries, so the structuring agents, the rating agencies, everybody, and certainly the investors, everybody's kind of aligned in thinking about it from the perspective of if you have one closing and it's fully funded, that's the ideal. That's the Rolls-Royce. That's the easiest to underwrite, easiest to sell, easiest to get a good rating on and then everything else, like the more components, the more flexibility you need as a sponsor, everything else kind of notches and eats into that. Is it doable? Absolutely. A lot of, you know, I would say like premium sponsors, global sponsors, really niche type strategies are also getting done these days and they're getting done quite successfully. It's become more and more innovative and how the structures are kind of put together. And again, diversity and cash flows are going to be at the very top of the list. And setting that LTV as well is going to be a key component. But are you going to face a lot more time on that runway versus a vertical or even a horizontal into a fund? Absolutely. They tend to take maybe up to six months, whereas a normal-course rated note fund might take you, I don't know, four to six weeks sometimes if it's a vertical. And then anything horizontal will probably be in the middle there. But lots of innovation in this space and frenetic energy. It's kind of an exciting time to be practicing here.

LT (33:18)
It absolutely is. It's, yeah, this is one of those things where, you know, I'm sure that there are loads of people who would love to snooze through this, but this is what gets me and Kate out of bed in the morning and constantly chatting with each other about what we're seeing, what we're thinking, just coming up with different things and ideas. You know, we love what we do and we would love to talk to you about it as well. ⁓ We will continue, obviously, as we have promised, doing new episodes with different things that we're seeing, different products. We are looking forward to having some guests on soon as well, some third-party guests. And our next episode that you will be seeing is another component of our SCIS practice, which is ⁓ captive CLO equity structures and dealing with European risk retention requirements with Jared Axelrod. We look forward to seeing you all. Give us a follow. And if you have any questions, please reach out to us, and we will be happy to speak with you. Thanks, Kate.

KL (34:14)
Thank you.